What is the formula to calculate the Netting Factor (NF)?

The formula for calculating the Netting Factor (NF) is integral to understanding how correlations among credit exposures impact overall portfolio risk. The correct formula expresses the way in which both the number of entities in a portfolio and their average correlation influence the aggregation of risk reductions gained by netting credit exposures.

In the selected formula, the square root of the term combines both the number of entities (n) and the average correlation among them. Specifically, it reflects how diversification effects come into play in reducing the total risk of a portfolio. The term n x (n-1) in the formula highlights the interactions between different entities and how their correlations contribute to the risk; this is crucial in understanding the dynamics of exposure netting.

Using the square root function is standard in risk management calculations as it helps to adjust for the increased risk that comes from multiple correlated exposures. When there is high correlation among entities, the square root accounts for the way that risk does not simply add up, but rather behaves multiplicatively.

The formulation results in a Netting Factor that gives credit to the benefits of diversification through netting, confirming that actual exposure and risk are less than the sum of individual components due to offsetting movements in the case of correlated defaults.

This understanding is essential for